Kiel Working Papers, Kiel Institute for World Economics
No 1794:
Financial Intermediation and the Role of Price Discrimination in a Two-Tier Market
Stefan Reitz, Markus A. Schmidt and Mark P. Taylor
Abstract: Though unambiguously outperforming all other financial
markets in terms of liquidity, foreign exchange trading is still performed
in opaque and decentralized markets. In particular, the two-tier market
structure consisting of a customer segment and an interdealer segment to
which only market makers have access gives rise to the possibility of price
discrimination. We provide a theoretical foreign exchange pricing model
that accounts for market power considerations and analyze a database of the
trades of a German market maker and his cross section of end-user
customers. We find that the market maker generally exerts low bargaining
power vis-á-vis his customers. The dealer earns lower average spreads on
trades with financial customers than commercial customers, even though the
former are perceived to convey exchange-rate-relevant information. From
this perspective, it appears that market makers provide interdealer market
liquidity to end-user customers with cross-sectionally differing spreads
Keywords: Foreign Exchange, Market Mictrostructure, Pricing Behavior; (follow links to similar papers)
JEL-Codes: F31,; F41; (follow links to similar papers)
40 pages, September 2012
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